A Macroeconomic Approach to Optimal Unemployment Insurance: Theory

This paper develops a theory of optimal unemployment insurance (UI) in matching models. The optimal replacement rate is the conventional Baily-Chetty replacement rate, which solves the tradeoff between insurance and job-search incentives, plus a correction term, which is positive when an increase in UI pushes labor market tightness toward its efficient level. Labor market tightness is generally inefficient because in matching models, most wage mechanisms do not ensure efficiency. The effect of UI on tightness depends on the model: UI may raise tightness by alleviating a rat race for jobs or lower tightness by increasing wages through bargaining.